Is Sterling Heading Toward The Abyss?

Sterling has been among the biggest losers in the past twelve months. The current prospects for the British currency in the short-term do not seem any better, too, but it may not be as doom and gloom as some would expect at the moment.

London - The pound saw its post-crisis peak against the US dollar on June 12 2014, when Bank of England Governor Mark Carney said the beginning of a tightening cycle in the UK could happen sooner than markets had been expecting. At that time, the economy was growing strongly and the UK labor market was tightening sharply. The combination of a confusing forward guidance together with a deluge of upbeat macro data only reinforced the governor's remarks.

Now in January 2016, sterling has plunged some 17% against the US dollar since Carney's June 2014 speech and the first rate hike at the Old Lady of Threadneedle Street after more than seven years of ultra-loose policy is still flickering far in the distance like a mirage. Although the jobless rate has continued to fall sharply, British employees are not getting any richer. Even with inflation hovering around zero, the real - meaning inflation adjusted - growth rate of the average weekly earnings is a mere 2%, down from the decade average of 2.4%.

Overall economic growth has slowed, and the financial market volatility and uncertainty spilling over from emerging markets has increased recently. The International Monetary Fund (IMF) cut the global economic forecast for 2016 to 3.4%, noting last week that risks remain tilted to the downside. At the same time, China's slowdown materialized with the industrial production slowing to 5.9% over the year in December from 6.2%, while GDP growth rose 6.8% in the final quarter of 2015, missing market forecasts.

Carney's first speech this year was overly dovish and was meant to be a reflection of those risks and uncertainties. And sterling's fall was only reinforced after the governor's comments. The weakness against the US dollar has also been driven by the marked policy divergence between the US Federal Reserve and the Bank of England (BoE), although some expect the Fed to be more cautious in tightening cycle following the first hike.

The pound's trade-weighted index slipped 8.5% against the US dollar since January last year, fell 9.2% against the Japanese yen, but ticked up 2.5% against the euro during the same period. Not much support for sterling is seen on the political front either, as the EU referendum looms. The plebiscite has been seen as one of the nation's most significant post-WWII political events.

Currency analysts from Rabobank wrote in a note this week that net sterling short positions had moved to their highest level since February of 2015.

They argued that "a slew of disappointing UK economic data releases and political uncertainty linked to the UK EU membership referendum are both negative factors for GBP".

Westpac Bank Corporation analysts see "a toxic brew of Brexit risk and near zero prospects of a BoE hike this year, and possibly until well into 2017" weighing on the pound.

Let's not be overly pessimistic

Sterling may not continue to plunge over the rest of the year as much as some expect at the moment. The economic prospects in the UK for this year remain more or less optimistic. Most forecasters see economic growth at a steady pace in the upcoming quarters, and the latest official figures showed the gross domestic product (GDP) output exceeded the pre-crisis peak [of January 2008] in the second quarter of 2013, and is now as much as 6.1% above this level.

Much will now depend upon the news that UK Prime Minister David Cameron's EU renegotiating team delivers after the February 18-19 Council meeting in Brussels. If the news are positive, and the UK manages to secure a deal on EU reforms, then one can expect a massive pro-EU campaign all the way until the plebiscite takes place. Some suggest the vote could take place as early as this summer.

The behind-the-scenes political talks between Westminster and European leaders so far appear positive, given the most recent comments by top officials, including the prime minister, and Chancellor George Osborne.

UK Secretary of State for Foreign and Commonwealth Affairs Philip Hammond said last week that, "June is certainly a possible date for a referendum, just looking at the time scales that are required to lay the necessary regulations for the referendum and to allow for the period for a referendum campaign."

On January 15, BBC News quoted Jean-Claude Juncker, the head of the European Commission, saying that he was "quite sure that we'll have a deal, not a compromise, a solution, not a mere compromise, a permanent solution in February."

So let us not be overly pessimistic on this front for now.

Given the current political atmosphere in the US ahead of the November presidential election, we might expect some downside risks to the US dollar. Even though the election results may not affect the state of the US economy per se, they may have significant impact on global security issues, which tend to skew currency curves in turn.

All in all, significant political events globally will again play their part this year in currency trading, as they did when the Scots were deciding on their independence back in 2014, or when euro zone leaders were desperately trying to avert the collapse of the euro currency a year ago, when Greeks rebelled.

Uncertainty, and the strength of policymakers' will to overcome it, will again play a big-time role this year.

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